CHAPTER 19 LEASE FINANCING(Difficulty: E = Easy, M = Medium, and T = Tough) True/False Easy: (19.1) Types of leases Answer: a Diff: E 1 . Many leases written today combine the features of operating and financial leases. Such leases are often called “combination leases.” a. True b. False (19.1) Types of leases Answer: a Diff: E 2 . A sale and leaseback arrangement is a type of financial, or capital, lease. a. True b. False (19.1) Operating lease Answer: a Diff: E 3 . Operating leases help to shift the risk of obsolescence from the user to the lessor. a. True b. False (19.1) Sale and leaseback Answer: a Diff: E 4 . Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor. a. True b. False (19.2) Lease payments Answer: a Diff: E 5 . The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines. a. True b. False Chapter 19: Lease Financing Page 1 False (19. True b.(19. True b. False Medium: (19. the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value. as a result of a statutory requirement to dispose of an asset in an environmentally sound manner. True b. False (19. the availability of lease financing cannot affect the size of the capital budget. and then leases it to the sponsoring corporation on a short-term basis. True b. leased assets and associated liabilities do not appear on the firm's balance sheet. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease. Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm's income statement and. The SPE borrows up to 97% of its capital.5) Leveraged lease Answer: b Diff: E 8 . a. a. False (19. False Page 2 Chapter 19: Lease Financing . Thus. False (19. a. for example.6) Residual value and lease rates Answer: b Diff: M 11 .4) Lease financing Answer: b Diff: E 7 .3) Off-balance sheet leasing Answer: a Diff: E 6 . A leveraged lease is more risky from the lessee’s standpoint than an unleveraged lease. a. Leasing is typically a financing decision and not a capital budgeting decision. If a leased asset has a negative residual value. a.1) Synthetic leases Answer: a Diff: M 10 . a. under certain conditions. True b. True b. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset.1) Synthetic leases Answer: b Diff: M 9 . uses its funds to buy the asset. This keeps both the asset and the debt off the sponsoring company’s books. d. From the lessee's viewpoint. c. a. Medium: (19. pension fund cash flows. with the possible exception of the residual value.6) Residual value and lease rates Answer: b Diff: M 12 .1) Operating lease 14 . is about the same as the riskiness of the lessee's a. From the lessee viewpoint. e. capital budgeting project cash flows. b. full amortization over the life of the lease. c. debt cash flows. e. equity cash flows. d. Chapter 19: Lease Financing Page 3 . Assume that a piece of leased equipment has a relatively high rather than low expected residual value. b. the riskiness of the cash flows. it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate.4) Lease cash flows Answer: c Diff: E 13 .(19. False Multiple Choice: Conceptual Easy: (19. Answer: a Diff: M maintenance of the equipment by the lessor. True b. restrictions on how much the leased property can be used. very high penalties if the lease is cancelled. much longer lease periods than for most financial leases. sales. Operating leases often have terms that include a. financial (or capital) leases must be included in the balance sheet by reporting the a. d. less the residual value. (19. Page 4 Chapter 19: Lease Financing . residual value as a fixed asset. make a company appear less risky than it actually is because its stated debt ratio will appear lower. whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment. the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds. residual value as a liability. undiscounted sum of future lease payments as an asset and as an offsetting liability. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement. the fixed payments associated with a loan. Heavy use of off-balance sheet lease financing will tend to Diff: M a. e. would show lower debt ratios if the effects of their leases were reflected in their financial statements. but never greater than. affect the lessee’s cash flows but only due to tax effects. A key difference between a capital lease and an operating lease is that with a capital lease. affect a company's cash flows but not its degree of risk. as an asset and as an offsetting liability. c. Firms that use "off balance sheet" financing. present value of future lease payments as an asset and also showing this same amount as an offsetting liability. Capital. make a company appear more risky than it actually is because its stated debt ratio will be increased. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure. b. e. b.(19.3) Off-balance sheet leasing Answer: b 17 . d. (19. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report.1) Leasing 15 . leases generally provide for maintenance by the lessor. c. or financial. b. undiscounted sum of future lease payments. such as leasing. in an amount sufficient to support the lease payment obligation. Which of the following statements is most CORRECT? Answer: e Diff: M a. c. e. d.3) Capitalizing leases Answer: c Diff: M 16 . The fixed charges associated with a lease can be as high as. c..(19. c. In the lease versus buy decision. d. because it has no effect on the firm's ability to borrow to make other investments. Multiple Choice: Problems Easy: (19. b. is financed with long-term debt. d. at the WACC. i. e. (19. no down payment is required. Sutton can also lease the equipment for 5 end-of-year payments of $1. a. is financed with a mix of debt and equity based on the firm’s target capital structure. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.000.000 bank loan to finance service equipment. The loan has an interest rate of 10% and would be amortized over 5 years. is financed with debt whose maturity matches the term of the lease. leasing is often preferable Diff: M a. c. is financed with retained earnings.215 $217.4) Lease analysis discount rate Answer: c Diff: M 19 .854 $207.455 Chapter 19: Lease Financing Page 5 . e.576 $228. Sutton Corporation. because. is considering a 5-year. because lease obligations do not affect the firm’s risk as seen by investors. which has a zero tax rate due to tax loss carryforwards. e. A lease versus purchase analysis should compare the cost of leasing to the cost of owning. with 5 end-of-year payments.4) Lease decision Answer: e 18 .4) Difference in payments Answer: c Diff: E 20 .000 each. b. b. generally. $177. is financed with short-term debt.169 $196. $6. and there are no indirect interest costs. because the lessee owns the property at the end of the least term. d. assuming that the asset purchased a. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.790.e. at 10% and buy the tools.000 and falls into the MACRS 3year class. and the loan would be amortized over the truck’s 4-year life. The tools will be obsolete and worthless after 3 years. and 0. e. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life.000. 0. $96 $106 $112 $117 $123 Tough: (19. Annual maintenance costs associated with ownership are estimated at $240. The truck will be used for 4 years. Dakota Trucking Company (DTC) is evaluating a potential lease for a truck with a 4-year life that costs $40. c. which include maintenance.000. What is the net advantage to leasing (NAL).07.000 per year. b. the purchase price. Kohers Inc. at the end of which time it will be sold at an estimated residual value of $10. or it can make 3 equal end-of-year lease payments of $2. e. d. Should the firm lease or buy? (Note: MACRS rates for Years 1 to 4 are 0.047 Page 6 Chapter 19: Lease Financing . is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. b.4) Net advantage to leasing (NAL) Answer: b Diff: M 21 .45. payable at the end of each year. $849 $896 $945 $997 $1. call for a $10. but this cost would be borne by the lessor if it leases. c. in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.33. d.800. The lease terms. The loan payments would be made at the end of each year.) a.Medium: (19. with interest paid at the end of the year. The firm's tax rate is 40%.000. If the firm borrows and buys the truck. It can borrow $4. the loan rate would be 10%. 0.100.4) Lessee's analysis Answer: d Diff: T 22 . so the interest expense for taxes would decline over time. The loan obtained from the bank is a 3-year simple interest loan.000 lease payment (4 payments total) at the beginning of each year.000 each and lease them.) a. it would purchase a maintenance contract that costs $1. If DTC buys the truck.15. DTC's tax rate is 40%. The estimated value of the equipment after 3 years is $30. b.972 Chapter 19: Lease Financing Page 7 . e.(19. Buster’s Beverages is negotiating a lease on a new piece of equipment that would cost $100.000.640 $6. The equipment falls into the MACRS 3-year class. payable at the beginning of each year. it will buy it. $5.000 if purchased. Alternatively. If there is a positive Net Advantage to Leasing the firm will lease the equipment.736 $6.4) Lessee's analysis Answer: a Diff: T 23 . payable at the beginning of each year. because the firm plans to move to a new facility at that time.000 per year. interest payable at the end of the year.324 $6. the firm could lease the equipment for 3 years for a lease payment of $29. and it could obtain a 3-year simple interest loan. to purchase the equipment at a before-tax cost of 10%. The firm is in the 20% tax bracket. c. What is the NAL? a. and it would be used for 3 years and then sold.023 $6. d.000 per year. A maintenance contract on the equipment would cost $3. Otherwise. The lease would include maintenance. CHAPTER 19 ANSWERS AND SOLUTIONS Page 8 Chapter 19: Lease Financing . (19.4) Lease cash flows 14.6) Residual value and lease rates 12.3) Capitalizing leases 17.(19.(19.(19.(19.(19.1) Sale and leaseback 5.(19.2) Lease payments 6.1.(19.1) Synthetic leases 10.1) Leasing 16.(19.1) Operating lease 4.1) Operating lease 15.(19.4) Lease analysis discount rate Answer: a Answer: a Answer: a Answer: a Answer: a Answer: a Answer: b Answer: b Answer: b Answer: a Answer: b Answer: b Answer: c Answer: a Answer: e Answer: c Answer: b Answer: e Answer: c Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: M Diff: M Diff: M Diff: M Diff: E Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M .(19.1) Types of leases 2.(19.(19.(19.1) Synthetic leases 11.(19.4) Lease financing 8.6) Residual value and lease rates 13.3) Off-balance sheet leasing 7.(19.(19.5) Leveraged lease 9.1) Types of leases 3.4) Lease decision 19.(19.(19.3) Off-balance sheet leasing 18. 215.100 840 -1.(19.000.260 -2.000 0 Loan: -$6.100 Tax rate: Maintenance costs: Salvage value: Answer: b Diff: M 40% $240 $0 After tax cost of debt = Rate × (1 − T) = 6.(19.474 -2.000 10.600 Tax saving from deprn = Deprn × T = $640 0 Cost of owning: Interest Interest tax saving Maintenance Maintenance tax saving Deprn tax saving Repayment of loan Net cash loan costs PV cost of owning (6%): Cost of leasing: Lease payment Tax savings from lease Net cash lease costs PV cost of leasing (6%): 1 -480 192 -240 96 640 208 -3.000 1 PMT 2 PMT 3 PMT 4 PMT Answer: c Diff: E 5 PMT Find the loan payment: Financial calculator solution: Inputs: N = 5.800 -4. FV = 0.790.4) Difference in payments Years: 5 Loan amount: $6.582.000 Interest rate: 10.785 = $207.800 10. 21.592 NAL = PV Cost of Owning − PV Cost of Leasing = $106.100 840 -1.000 HARD .260 -3.582.785 Difference in payments = $1.790. Output = PMT = $1.260 2 -480 192 -240 96 640 208 3 -480 192 -240 96 640 -4.4) Lessee's analysis Life of equipment: Loan amount = equipment cost: Interest rate: 4 $40. I/YR = 10.100 840 -1.20.000.0% $2.0% Tax rate: Maintenance costs: Salvage value: Answer: d 40% $1.(19.000.4) Net advantage to leasing (NAL) Years: Loan amount = equipment cost: Interest rate: Lease Pmt: 3 $4.368 -2.0% Lease Pmt: $1. 22.000 $10.000.000 – $1.0% Depreciation per year = Cost/3 = $1. PV = -6. 000 0 Tax rate: Maintenance costs: Salvage value: 1 0.472 PMT 12.000 3. I/YR = 10.618.000 4 0 0 0 Beg.33 33.000 -6.619 12.038 1 -10.000 -6. tax saving (Maint.000 4.000 .943 4 0.000 Loan amortization for cash payment and interest expense: Payment: N = 4.4) Lessee's analysis Life of equipment: Loan amount = equipment cost: Interest rate.280 -6.000 Answer: a 20% $3.000 -12.000 HARD Totals 0.764 -9.481 10.619 9.83 Year 1 2 3 4 Loan Analysis: MACRS factor Depreciation Loan Pmt Int tax saving (Int.640 10.45 45.147 Principal 8.000 3 -10.000 -22. from table × T)) Maintenance Maint.619 1. simple: Lease Pmt: Loan Analysis: MACRS factor Depreciation 3 $100.000 -12.619 0 Interest 4.900 11. FV = 0. PMT = -$12.619 876 -1.381 21.00% Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I(1 – T) NAL = $997 -23.45 18.000 400 5.(19.15 6.472 0 3 0.07 2.339 -4.200 -12.400 -9.619 12. PV = 40000. 31.000 -5.138 2.000 400 2.000 4.000 400 1.000 4.000 2 0.000 31. 40.0% $29.764 -6.429 11.900 11. Bal.381 21. × T) Depr'n tax saving (Deprn × T) Net operating CF Salvage value Tax on residual Net residual val Total Net CF PV cost of buying at I(1 – T) = 6.33 13.000 $30.000 -6.600 -1.120 -11.619 459 -1.190 1.255 -1.000 2 -10.000 3 0.640 2 0.472 1 0.619 1.000 -6.800 -12.035 0 -10.000 10.15 15.000 6.Lease Pmt: $10.339 Ending Bal.000 4.200 -4.943 23.93 93.619 12.000 -4.000 400 7. 000 -4.200 -1.000 -10.000 2.800 -23.000 -3.000 7.800 -23. tax saving (Maint.400 2 -29.200 -64. × T) 600 Depr'n tax saving (Deprn × T) Net operating CF -2.736 0 -29.000 Maint.000 2.000 5.000 5.00% -70.308 Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I(1 − T) NAL = $5.000 30.Loan repayment Interest Int tax saving (Interest × T)) Maintenance -3.400 PV cost at I(1 − T) = 8.600 -3.000 -1.600 25.000 5.000 600 6.400 Salvage value before taxes Book value (Cost − Total dep'rn) Taxable salvage value Tax on salvage value Salvage value after taxes Total Net CF .2.000 2.800 -10.800 1 -29.600 3 0 0 .800 -23.000 -3.000 23.200 3.000 -3.000 -105.400 -79.000 600 9.400 -100.572 -10.